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In products that are distributed and sold via the freemium model, since users of the free product do not pay companies actual cash money, how should a company determine their value?

Professors Vineet Kumar , Clarence Lee and Sunil Gupta have been studying economic models of freemium companies to understand customer behavior and how companies can maximize profit using freemium pricing. In their paper, Designing Freemium: a Model of Consumer Usage, Upgrade and Referral Dynamics the authors warn, “Taking a narrow view of the consumer can be highly inaccurate.”

So what is the broad view they are advocating? The value of a non-paying customer in a freemium environment is mostly the potential revenue they can produce. For all freemium companies, it can be categorized in three ways:

Personal usage. The more an individual uses a product, the more likely he will upgrade to a paid product

Social usage. The social act of sharing raises the probability that the sharing consumers will convert to paid premium consumers

Word-of-Mouth. Free consumers bring in other consumers who may become premium users

In a recent interview, Kumar says that for new companies there is also a fourth area of value:

Start-up value: Proof of concept is often needed for further fund-raising

“The first goal of a start-up,” explained Kumar, “is not to go bust. And going bust is very easy to do if you are a freemium company, if you don’t choose the features right." He cited the company billing management software company Chargify, featured in a recent article, as an example of a failed freemium effort.

“There’s a big trade-off. So if you don’t put enough in there, no one is going to sign up. And for start-ups, that is the only way to get attention. So the way I would think about it, give a lot of value with the free version. Then have something -- say one feature that is very compelling to a subset of users that they would be willing to pay for – to prove value for money.

“And that’s the challenge. How do you choose and how do you create that?”

Established companies have a different dynamic in implementing freemium pricing than start-ups, says Kumar. “There is a relatively long time frame -- if the consumer gets monetized over the next year or the next couple of years, that’s fine, they can wait.”